Chapter 9. Procurement and Outsourcing Strategies

downtownbeeMechanics

Nov 18, 2013 (3 years and 11 months ago)

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Chapter 9

Procurement and Outsourcing
Strategies

1

9.1 Introduction


Outsourcing components have increased
progressively over the years


Some industries have been outsourcing for an
extended time


Fashion Industry (Nike) (all manufacturing outsourced)


Electronics Industry


Cisco (major suppliers across the world)


Apple (over 70% of components outsourced)

2

Not Just Manufacturing but Product
Design, Too…


Taiwanese companies now design and
manufacture most laptop sold around the
world


Brands such as Hewlett
-
Packard and PalmOne
collaborate with Asian suppliers on the design
of their PDAs.

3

Questions/Issues with Outsourcing


Why do many technology companies
outsource manufacturing, and even
innovation, to Asian manufacturers?


What are the risks involved?


Should outsourcing strategies depend on
product characteristics, such as product
clockspeed, and if so how?

4

Discussion Points


Buy/make
decision process


Advantages and the risks with outsourcing


Framework for optimizing buy/make decisions.


Effective procurement strategies


Framework for identifying the appropriate procurement strategy


Linkage of procurement strategy to outsourcing strategy.


The procurement process


Independent (public), private, and consortium
-
based e
-
marketplaces.


New developments mean higher opportunities and greater
challenges faced by many buyers

5

9.2 Outsourcing Benefits and Risks

Benefits


Economies of scale


Aggregation of multiple orders reduces costs, both in purchasing
and in manufacturing


Risk pooling


Demand uncertainty transferred to the suppliers


Suppliers reduce uncertainty through the risk
-
pooling effect


Reduce capital investment


Capital investment transferred to suppliers.


Suppliers’ higher investment shared between customers.

6

Outsourcing Benefits


Focus on core competency


Buyer can focus on its core strength


Allows buyer to differentiate from its competitors


Increased flexibility


The ability to better react to changes in customer demand


The ability to use the supplier’s technical knowledge to
accelerate product development cycle time


The ability to gain access to new technologies and innovation.


Critical in certain industries:


High tech where technologies change very frequently


Fashion where products have a short life cycle

7

Outsourcing Risks


Loss of Competitive Knowledge


Outsourcing critical components to suppliers may open
up opportunities for competitors


Outsourcing implies that companies lose their ability to
introduce new designs based on their own agenda rather
than the supplier’s agenda


Outsourcing the manufacturing of various components to
different suppliers may prevent the development of new
insights, innovations, and solutions that typically require
cross
-
functional teamwork

8

Outsourcing Risks

Conflicting Objectives


Demand Issues


In a good economy


Demand is high


Conflict can be addressed by buyers who are willing to make long
-
term commitments to purchase minimum quantities specified by a
contract


In a slow economy


Significant decline in demand


Long
-
term commitments entail huge financial risks for the buyers



Product design issues


Buyers insist on flexibility


would like to solve design problems as fast as possible


Suppliers focus on cost reduction


implies slow responsiveness to design changes.

9

Examples of Outsourcing Problems

IBM


PC market entry in 1981


Outsourced many components to get to market quickly


40% market share by 1985 beating Apple as the top PC
manufacturer


Other competitors like Compaq used the same suppliers


IBM tried to regain market by introducing the PS/2 line
with the OS/2 system


Suppliers and competitors did not follow


IBM market share shrunk to 8% in 1995


Behind Compaq’s 10% leading share


Led to eventual sale of PC business to Lenovo

10

Examples of Outsourcing Problems

Cisco


2000 problem:


Forced to announce a $2.2 billion write
-
down for obsolete
inventory


8,500 employees were laid off.


Significant reduction in demand for telecommunication
infrastructure


Problem in its virtual global manufacturing network


Long supply lead time for key components


Would have impacted delivery to customers


Cisco carried component inventory which were ordered long in
advance of the downturn.


Competition on limited supplier capacities


Long
-
term contracts with its suppliers

11

9.3 Framework for Make/Buy Decisions


How can the firm decide on which component
to manufacture and which to outsource?


Focus on core competencies


How can the firm identify what is in the core?


What is outside the core?

12

Two Main Reasons for Outsourcing


Dependency on capacity


Firm has the knowledge and the skills required to
produce the component


For various reasons decides to outsource


Dependency on knowledge


Firm does not have the people, skills, and knowledge
required to produce the component


Outsources in order to have access to these
capabilities.

13

Outsourcing Decisions at Toyota


About 30% of components in
-
sourced


Engines:


Company has knowledge and capacity


100% of engines are produced internally


Transmissions


Company has the knowledge


Designs all the components


Depends on its suppliers’ capacities


70 % of the components outsourced


Vehicle electronic systems


Designed and produced by Toyota’s suppliers.


Company has dependency on both capacity and knowledge

14

Outsourcing Decisions at Toyota


Toyota seems to vary its outsourcing practice
depending on the strategic role of the
components and subsystems


The more strategically important the component,
the smaller the dependency on knowledge or
capacity.

15

Product Architectures


Modular product


Made by combining different components


Components are independent of each other


Components are interchangeable


Standard interfaces are used


Customer preference determines the product configuration.


Integral product


Made up from components whose functionalities are tightly
related. =


Not made from off
-
the
-
shelf components.


Designed as a system by taking a top
-
down design approach.


Evaluated on system performance, not on component
performance


Components perform multiple functions.

16

A Framework for Make/Buy Decisions

Product

Dependency on
knowledge and
capacity

Independent for
knowledge,
dependent for
capacity

Independent for
knowledge and
capacity

Modular

Outsourcing is risky

Outsourcing is an
opportunity

Opportunity to
reduce cost
through
outsourcing

Integral

Outsourcing is very
risky

Outsourcing is an
option

Keep production
internal

Hierarchical Model to Decide Whether to
Outsource or Not


Customer Importance


How important is the component to the customer?


What is the impact of the component on customer experience?


Does the component affect customer choice?


Component Clockspeed


How fast does the component’s technology change relative to other
components in the system?


Competitive Position


Does the firm have a competitive advantage producing this component?


Capable Suppliers


How many capable suppliers exist?


Architecture


How modular or integral is this element to the overall architecture of the
system?


18

Examples of Decisions

Criteria

Example 1

Example 2

Example 3

Example 4

Customer
Importance

Important

Not important

Important

Important

Clockspeed

High

Slow

High

Slow

Competitive
Position

Competitive
Advantage

No advantage

No advantage

No advantage


Capable Suppliers

X

X

Key variable to
decide strategy

Architecture

X

X

Key variable to
decide strategy

DECISION

Inhouse

Outsource

Inhouse, Acquire
supplier,
Partnership

Outsource with
modular;
Inhouse

or joint
development with
integral.

9.4 Procurement Strategies


Impact of procurement on business performance


2005 profit margins for Pfizer (24%), Dell (5%), Boeing
(2.8%).


Reducing procurement cost by exactly 1% of revenue
would have translated directly into bottom line, i.e., net
profit.


To achieve the same impact on net profit through higher
sales


Pfizer would need to increase its revenue by 4.17 (0.01/0.24) %


Dell by 20% and Boeing by 35.7%


The smaller the profit margins, the more important it is
to focus on reducing procurement costs.

20

Appropriate Strategy


Depends on:


type of products the firm is purchasing


level of risk


uncertainty involved


Issues:


How can the firm develop an effective purchasing strategy?


What are the capabilities needed for a successful procurement
function?


What are the drivers of effective procurement strategies?


How can the firm ensure continuous supply of material without
increasing its risks?

21

Kraljic’s Supply Matrix



Firm’s supply strategy should depend on two
dimensions


profit impact


Volume purchased/ percentage of total purchased cost/
impact on product quality or business growth



supply risk


Availability/number of suppliers/competitive demand/
make
-
or
-
buy opportunities/ storage risks/ substitution
opportunities

22

Kraljic’s Supply Matrix

FIGURE 9
-
4:
Kraljic’s

supply matrix

23

Kraljic’s Supply Matrix


Top right quadrant:


Strategic items where supply risk and impact on profit are high


Highest impact on customer experience


Price is a large portion of the system cost


Typically have a single supplier


Focus on long
-
term partnerships with suppliers


Bottom right quadrant


Items with high impact on profit


Low supply risk (
leverage items)


Many suppliers


Small percentage of cost savings will have a large impact on
bottom line


Focus on cost reduction by competition between suppliers


24

Kraljic’s Supply Matrix


Top left quadrant:


High supply risk but low profit impact items.


Bottleneck components


Do not contribute a large portion of the product cost


Suppliers have power position


Ensure continuous supply, even possibly at a premium cost


Focus on long
-
term contracts or by carrying stock (or both)


Bottom left quadrant:


Non
-
critical items


Simplify and automate the procurement process as much as
possible


Use a decentralized procurement policy with no formal
requisition and approval process

25

Supplier Footprint


Supply Strategies have changed over the years


American automotive manufacturers


1980s: Suppliers either in the US or in Germany.


1990s: Suppliers in Mexico, Spain, and Portugal.


2000s: Suppliers in China


High
-
tech industry


1980s: Sourcing in the US


1990s: Singapore and Malaysia


2000s: Taiwan and mainland China


Challenge:


Framework that helps organizations determine the appropriate
supplier footprint.


Strategy should depend on the type of product or component
purchased

26

Fisher’s Functional vs. Innovative Products

Functional Products

Innovative Products

Product
clockspeed

Slow

Fast

Demand
Characteristics

Predictable

Unpredictable

Profit Margin

Low

High

Product Variety

Low

High

Average forecast error
at the time production
is committed

Low

High

Average stockout rate

Low

High

Supply Chain Strategy


Functional Products


Diapers, soup, milk, tiers


Appropriate supply chain strategy for functional products is
push


Focus: efficiency, cost reduction, and supply chain planning.


Innovative products


Fashion items, cosmetics, or high tech products


Appropriate supply chain strategy is pull


Focus: high profit margins, fast clockspeed, and unpredictable
demand, responsiveness, maximizing service level, order
fulfillment

28

Procurement Strategy for the Two Types


Functional Products


Focus should be on

minimizing total landed cost


unit cost


transportation cost


inventory holding cost


handling cost


duties and taxation


cost of financing


Sourcing from low
-
cost countries, e.g., mainland China and
Taiwan is appropriate


Innovative Products


Focus should be on
reducing lead times and on supply flexibility.



Sourcing close to the market area


Short lead time may be achieved using air shipments

29

Sourcing Strategy for Components


Fisher’s framework focuses on finished goods
and demand side


Kraljic’s framework focuses on supply side


Combine Fisher’s and Kraljic’s frameworks to
derive sourcing strategy

30

Integrated Framework


Component forecast accuracy


Component supply risk


Component financial impact


Component clockspeed


31

Component Forecast Accuracy



Not necessarily the same forecast accuracy as for finished
goods


Risk pooling concept implies higher accuracy for components


Sourcing strategy may be minimizing total landed costs, lead
time reduction, or increasing flexibility.


Cost
-
based sourcing strategy


High component forecast accuracy/Low supply risk/High financial
impact/Slow is appropriate.


Lead time reduction strategy


Low component forecast accuracy/High financial risk/Fast clockspeed


Flexibility and lead time strategy


Low component forecast accuracy/High financial risk/Fast
clockspeed/High supply risk

32

HP’s Portfolio Strategy


Exponential growth in demand for Flash memory
resulted in high demand uncertainty


Uncertain price and supply


Significant financial and supply risk.


Commitment to purchase large amount of inventory


huge financial risk through obsolescence cost.


Not have enough supply to meet demand


both supply risk and financial risk


purchasing from the spot market during shortage periods yield to
premium payments


HP’s solution: the portfolio strategy


Combined fixed commitment, option contracts, and spot
purchasing

33

Qualitative Approach to Sourcing Strategy

FIGURE 9
-
5: A qualitative approach for evaluating component sourcing strategy

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9.5 E
-
Procurement


Mid to late 90s: B2B automation was considered a
trend that would have a profound impact on supply
chain performance.


1998
-
2000:


Multiple e
-
markets established in various industries


Promised:


increased market reach for both buyers and suppliers


reduced procurement costs


paperless transactions


Processing cost per order proposed to be reduced to
$5/order from as high as $150/order

35

Business Environment in the 1990s


Many manufacturers desperately looking to outsource
their procurement functions.


Procurement process highly complex, significant
expertise required and expensive


B2B transactions an enormous portion of the economy
(much larger


B2B marketplace highly fragmented


a large number of suppliers


competing in the same marketplace


offering similar products.


Opportunities and challenges


Lowered procurement costs (Suppliers)


Significant expertise in procurement process absent (Buyers)

36

Opportunities for the Marketplaces


Initial offerings of independent e
-
marketplaces


Either a vertical
-
industry focus or a horizontal
-
business
-
process or a functional focus.


Companies offered:


expertise in the procurement process


ability to force competition between a large number of
suppliers.


37

Value Proposition to Buyers


Serving as an intermediary between buyers and
suppliers.


Identifying saving opportunities.


Increasing the number of suppliers involved in
the bidding event.


Identifying, qualifying, and supporting suppliers.


Conducting the bidding event.


38

The Result


Reduction in procurement costs from 15
-
40%


Buyers focused on the spot market or on
leverage component


Long term relationships with suppliers not
important


Value proposition to suppliers not clear

39

Benefits of e
-
markets to Suppliers


Relatively small suppliers could expand their market
horizon


Allows suppliers to access spot markets.
Advantageous in:


Fragmented markets


Reducing marketing and sales costs


Increasing ability to compete on price.


Allows suppliers to better utilize their available
capacities and inventories.

40

Issues of the Benefits


Do the benefits compensate for a reduction in
revenue?


Average 15%, sometimes as high as 40%.


Many suppliers may not feel comfortable
competing on price alone.


Suppliers, especially those with brand
-
name
recognition, may resist selling their services
through e
-
markets.

41

What about the e
-
markets Themselves?


Revenue generation through transaction costs


Typically 1
-
5% of price paid by buyer


Transaction fees pose serious challenges to the market
maker:


Sellers resist paying a fee to the company whose main objective
is to reduce the purchase price.


Revenue model needs to be flexible enough so that transaction
fees are charged to the party that is more motivated to secure
the engagement.


Buyers also resist paying a fee in addition to the purchase price.


Low barriers to entry created a fragmented industry

42

Fragmented e
-
markets in the Chemical
Industry


About 30 e
-
markets


CheMatch, e
-
Chemicals, ChemB2B.com,
ChemCross, OneChem, ChemicalDesk,
ChemRound, Chemdex…


Low margins and inability to build scale resulted in
a major shake
-
up of this industry

43

Challenges Lead to Evolution of the e
-
markets


Changes in the way clients are charged


Licensing fee



software vendor licenses its software so that the
company can automate the access to the marketplace


Subscription fee


marketplace charges a membership fee


Fee depends on the size of the company, the number of
employees who use the system, and the number of
purchase orders

44

Challenges Lead to Evolution of the e
-
markets


Modification of value proposition


Initial proposition was market reach


Changed through creation of four types of
markets.

45

Value
-
Added Independent Public e
-
Markets


Expanded value proposition by offering additional
services:


inventory management


supply chain planning


financial services


Examples:


Instill.com focuses on the food service industry


Provides an infrastructure that links together operators


Additional services like forecasting, collaboration, and replenishment
tools.


Pefa.com services the European fresh fish market


Offers buyers access to a large number of independent fresh fish
auctions.


Provide visibility on price from many European ports


Provide information on product quality

46

Private e
-
markets


Many companies have established their own private e
-
markets


Key activities:


to run reverse auctions


on
-
line supplier negotiation.


Examples:


Subway restaurant franchise


16,000 members in over 70 countries


Allows the different restaurants to purchase from over 100 suppliers.


Motorola


Implemented supplier negotiation software


Allows firm to conduct bids, negotiate and select an effective
procurement strategy.

47

Consortia
-
Based e
-
markets


Similar to public e
-
markets


Established by a number of companies within the same
industry.


Examples:


Covisint in the automotive industry


Exostar in the aerospace industry


Trade
-
Ranger in the oil industry


Converge and E2Open in the electronic industry.


Provides suppliers with a standard system that supports
all the consortia’s buyers


Some of the consortia have exited the auction business


Focus on technology that enables business collaboration
between trading partners (Examples: Covisint and E2Open)

48

Content
-
Based e
-
markets


Two types of markets


Maintenance, repair, operations (MRO) goods


Industry
-
specific products.


Focus on content


Achieved by integrating catalogs from many industrial
suppliers.


Unify suppliers’ catalogs


Provide effective tools for searching and comparing
suppliers’ products.


Example:


Aspect Development (now part of i2) offers electronics
parts catalogs that integrate with CAD systems.

49

SUMMARY


Outsourcing has both benefits and risks


Buy/make decisions should depend on:


Whether a particular component is modular or integral


Whether or not a firm has the expertise and capacity to manufacture a
particular component or product.


Variety of criteria including customer importance, technology
clockspeed, competitive position, number of suppliers, and product
architecture.


Procurement strategies vary from component to component


Four categories of components, strategic, leverage, bottleneck and
non
-
critical items


Four categories important in selecting suppliers: component
forecast accuracy, clockspeed, supply risk, and financial
impact.

50